Consistent with the current macroeconomic trends, railroads started the year on a mixed note. Going by the rail traffic report for the first quarter 2013, growth in automotive and petroleum products’ shipments was steady while coal and grain shipments continued to cast a shadow over the rail freight industry.

According to the Association of American Railroads’ (AAR) rail traffic report, cumulative performance of the North American railroads (including U.S., Canadian and Mexican railroads) have fallen 1.5% year over year in the first quarter of the year. The biggest contributor to this decline was grain, which dropped 11%. Coal volumes followed closely, falling around 7%.

Going by the quarterly performance of the class 1 railroad, we see continued lower volumes from most of these carriers. One of the largest class 1 railroads in North America — Union Pacific Corp. (UNP) — registered first quarter volume decline of 2% year over year. Another major railroad CSX Corp. (CSX) also reported a similar level of decline in its volumes. Going forward, Canadian counterpart, Canadian Pacific Railway Ltd. (CP) also experienced lackluster growth trend with flat volume growth on a year-over-year basis.

However, railroad operators like Kansas City Southern (KSU), Norfolk Southern Corp. (NSC) and Canadian National Railway Company (CNI) have shown modest volume growth, mainly driven by the emerging automotive business and rising petrochemical shipments.

Notably, despite mixed carload results, these carriers have mostly generated positive earnings in the reported quarter. The primary catalyst to this bottom-line performance was operational efficiency even in times of low market demand. Rising employee productivity, deploying fuel-efficient locomotives and undertaking railroad safety measures are some of the key drivers of profitability even in adverse market conditions.

Rail carriers like Canadian Pacific recorded operating ratio improvement of 430 basis points year over year. Continued focus on maintaining asset efficiencies, safety measures and increased productivity have been the prime contributors to Canadian Pacific’s success in the first quarter. There are several other near-term growth catalysts in the railroad industry.

Rising Contribution of Petroleum Product Shipment

According to the AAR report, rail traffic from petroleum products has seen a whopping 46% growth in the three-month period ended Mar 30. According to the Energy Information Administration’s (EIA) reports, U.S. crude oil exceeded 7 million barrels per day production, representing record growth since the last two decades. Further, in 2013, long-term projections of EIA suggest that this growth may also go up to 10 million barrels per day over a period of 2020 to 2040.

As a result, this surge represents a potential opportunity for revenue accretion, which the railroads are trying to tap with infrastructural development. According to industry sources, the role of crude oil as a revenue contributor has grown by leaps and bounds in a four-year span from a mere 3% to 30% of the oil and petroleum products shipment by railroads.

Despite the fact that rail-based crude transportation costs five times more ($10–$15 per barrel), crude shippers are compelled to rely on rail-based transport. This is due to the lack of pipeline infrastructural support in key oil and gas fields like Bakken Shale Formation in North Dakota and Montana, Eagle Ford Shale, Barnett Shale and Permian basin in Texas, the Gulf of Mexico and Alberta oil sand fields in Canada.

In 2012, Canadian National Railway, which operates along the Western Canada (Alberta region) to the Gulf Coast, has shipped approximately 30,000 tank cars of volumes of crude oil, while its counterpart Canadian Pacific shipped 53,000 tank cars of crude during the same period. Another giant railroader, BNSF Railroad of Berkshire Hathaway Inc. (BRK-B), which serves the North Dakota region reportedly earned $272 million from crude shipments last year by shipping approximately 100 million barrels of oil.

In the coming days, we expect railroads to accelerate their investment in order to create adequate service capacity for the oil and gas markets. Canadian Pacific projects crude shipment to reach up to 70,000 oil-tank cars by the year-end and move to 140,000 by the end of 2015. This kind of exponential growth in crude oil shipments is taking place across the rail industry. Consequently, we expect petroleum shipments to remain favorable and emerge as a significant revenue contributor in the long term.

Automotive

Currently, Mexico is a growing market for automotive production and assembly given the lower cost of production there. As a result, markets sources predict that in the coming years, auto manufacturers are expected add capacity to accelerate manufacturing by 600,000 additional vehicles per annum. In the first three months of 2013, auto shipments by rail in Mexico increased 4.6% while in the U.S., auto shipment via rail rose about 2%. This counterbalanced the 1% drop in rail auto shipments in the Canadian market.

We believe upcoming plants by Honda Motor Co., Ltd. (HMC), Nissan Motor Co. (NSANY), Mazda and Audi would further boost auto production in Mexico. The facilities would also bode well for automotive shipments. Based on these proposed expansion plans, finished vehicle production in the Mexican market is expected to reach 3.5 million units in 2015, up about 35% from the 2012 production level.

The growth will provide carriers like Kansas City Southern, which operates across the Gulf of Mexico, ample opportunities to ship raw material into Mexico and return the finished products to the domestic market as well as to the U.S. and Canada. The increase in automotive production is also giving rise to new steel plants and processing centers across the company’s service networks. These steel plants are likely to bring opportunities for steel shipments and other related products.

However, in the coming year, the growth can be slightly muted by the onslaught of the fiscal cliff. According to market reports, auto sales may see single-digit growth due to a change in consumer behavior owing to the U.S. tax policy changes. If the situation improves on the macro front, there should not be a cyclical downturn in the way of automotives.

Intermodal

The railroad industry is gaining largely from the ongoing conversion of traffic from truckload to rail intermodal. Intermodal is gaining popularity among shippers given its cost effectiveness over truck. On average, railroads are considered 300% more fuel-efficient than trucks, and we believe that intermodal will play an important role in driving the rail industry based on the growing awareness among shippers about its benefits.

Currently, rail intermodal accounts for over 20% of the railroads’ revenue, second in line after coal. In the coming years, we expect this contribution to only rise given the growing dependence of shippers on intermodal services.

Apart from these positives, other factors likely to have a material impact on Railroads’ near-term, top and bottom line growth include:

Coal

Coal represents important commodities and accounts for over 40% of railroad tonnage. According to EIA reports, coal production hit lows of 9.9 million short tons (MMst) in first quarter 2013, representing a steep decline from 22.7 MMst in the year-ago quarter. As per AAR reports, coal shipments by rail also continued to decline 8% in the U.S. market. The decline was partially offset by 11% and 9% growth in rail shipments in the Mexican and Canadian markets, respectively.

Domestic coal demand, of which utility coal accounts for approximately 93%, is witnessing persistent declines. Lower natural gas prices imply that gas is largely substituting the demand for utility coal. Additionally, higher stockpile levels have resulted in lower utility coal demand. Besides, natural gas prices, another important factor that resulted in the decline of coal-powered plants are the environmental issues associated with coal burning.

However, in 2013, coal consumption in the domestic market is expected to grow 7% year over year to 948 MMst and reach up to 957 MMst in 2014 on the back of rising natural gas prices.

On the export front, the scenario remains entirely different. After reaching highs of coal export in 2012 (126MMst), EIA projects U.S. coal exports to decline 15% year over year to 107 MMst in 2013. However, 2014 may show modest improvement with exports of 109 MMst. Factors like an economic overhang in European markets, lower U.S. coal pricing, higher stockpile levels and increased exports from Indonesia as well as a recovery in the Australian mines are the primary reasons for the expected decline.

Grain Shipments

Since 2012, the Grain market has been experiencing lows due the drought in the Mid-West markets. The outlook for 2013 is also not encouraging enough to elevate rail freight shipment from its current lull.

According the rail traffic report of AAR, North American grain shipment registered a decline of almost 11% in the first three months of 2013, which was partially offset by 24.6% growth in Mexican grain shipment. In April, the U.S. Department of Agriculture (USDA) released the World Agricultural Supply and Demand Estimates (WASDE) report, which states that total U.S. corn demand, will go down by 11.1% from the year-ago level.

U.S. corn exports will hit a low of 48.2% from last year with use of ethanol decreasing 9.2%. We believe that the impact of lowered estimates would be felt on railroad shipment as rail freight serves the majority of export shipment in the crop market.

Rail Investments

Investment in development and expansion plans remain critical when analyzing railroads prospects. These capital investments are a double-edged sword. While the investments put significant stress on margin performance, forgoing these would result in a loss of growth prospects.

Railway investments are paramount given the evolving supply chain management and increasing role of airfreight carriers in offering freight transportation services. These investments build the required infrastructure needed for railways to stay afloat in a competitive environment not only within the railroad industry but also with other modes like truck, barges and cargo airlines.

As a result, investments in infrastructural projects have been an integral part of railroads development. However, this sector, characterized by huge capital influx has been drawing funds primarily through private financing.

As a result, investment plans when undertaken can have a considerable impact on the liquidity position of the company and may lead to a highly leverage balance sheet. According to AAR reports, railroads invest approximately 17% of their annualized revenue, which compares with only 3% of average U.S. manufactures’ revenue on capital expenditures.

According to the Department of Transportation (DOT), the demand for rail freight transportation will increase approximately 88% by 2035. As a result, Class I carriers would have to expedite their investments to meet this growing demand.

It is estimated that railroads would require $149 billion to improve rail network infrastructure within this stipulated period. In respect of current investment requirements, railroads would invest about $24.5 billion in 2013 according to AAR. This figures project an escalating trend when compared with recorded investment of $23 billion in 2012 and $12 billion in 2011 as per AAR.

Given the growing demand and need to upgrade railroad infrastructure to meet new regulations, deployment of fuel-efficient locomotives, upcoming rules on track sharing, railroad safety and high-speed rail services make it mandatory for railroads to infuse more capital on development projects. According to DOT, almost 90% of the railway capacity needs to be upgraded to meet the expected rise in demand level by 2035. Hence, for railroads it is important to balance profitability levels while investing in infrastructural development projects.

Currently, the U.S. railroad industry dominates less than 50% of total freight in America , indicating a huge opportunity for increasing market share. This opportunity can only be exploited by building railroad infrastructure that caters to the varied requirements of shippers.

OPPORTUNITIES

The railroad industry as a whole offers a number of opportunities that are difficult to ignore from the standpoint of investors.

Discretionary Pricing Power: The freight railroad operators function in a seller’s market and have enjoyed pricing power since 1980, when the U.S. government adopted the Staggers Rail Act. The idea was to allow rail transporters to hike prices on captive shippers like electric utilities, chemical and agricultural companies in order to improve profitability of the struggling railroad industry. As a result, of the Staggers Rail Act, railroads are hiking their freight rates by nearly 5% per annum on average, while maintaining a double-digit profit margin.

Duopolistic Market Structures: Railroads have by and large gained by practicing discretionary pricing in the freight market. In the prevailing duopolistic rail industry, railroad operators will be able to reap maximum benefits from rising prices when the overall demand grows.

This remains evident from the geographic distribution of markets between major railroads. Union Pacific and Burlington Northern Santa Fe control the western part of the U.S., while CSX Corp. and Norfolk Southern control the eastern part. On the other hand, Canadian Pacific and Canadian National control inter country rail shipment between the U.S. and Canada.

CHALLENGES

Despite the above mentioned positives, the freight railroad industry, like other industries, faces certain external and internal challenges. These are as follows:

Capital Intensive Nature: Railroad is a highly capital intensive industry that requires continued infrastructural improvements and acquisition of capital assets. Moreover, industry players access the credit markets for funds from time to time. Adverse conditions in credit markets could increase overhead costs associated with issuing debt, and may limit the companies’ ability to sell debt securities on favorable terms.

Positive Train Control Mandate: The Rail Safety Improvement Act 2008 (RSIA) has mandated the installation of PTC (Positive Train Control) by Dec 31, 2015 on main lines that carry certain hazardous materials and on lines that involve passenger operations. The Federal Railroad Administration (FRA) issued its final rule in Jan 2010, on the design, operational requirements and implementation of the new technology. The final rule is expected to impose significant new costs for the rail industry at large.

Price Regulations: The pricing practices of U.S. freight railroads are the major reasons of friction with captive shippers, who move their products through rail and do not have effective alternatives. According to the latest studies by the STB, approximately 35% of the annual freight rail is captive to a single railroad, allowing it monopoly pricing practices.

The unfair pricing power exhibited by the U.S. railroads has attracted congressional intervention for exercising stringent federal regulations on railroads. Congress has discussed railroad price regulation but has not passed any new rule so far.

U.S. Environmental Protection Agency: Railroads remain concerned about the proposed regulation by the U.S. Environmental Protection Agency (EPA) for power plants across 27 states. The proposed guideline –– Carbon Pollution Standard for New Power Plants –– aims at restricting emission of carbon dioxide by new power plants under Section 111 of the Clean Air Act. The standard proposes new power plants to limit their carbon-dioxide emission to 1,000 pounds per megawatt-hour.

Power plants fueled by natural gas have already met these standards but the majority of the units using conventional resources like coal are exceeding the set limit, as they emit an average of 1,800 pounds of carbon-dioxide per megawatt-hour. Railroads, which transport nearly two-thirds of the coal shipment, are most likely to be impacted by the implementation of the new regulation that could pose a significant threat to utility coal tonnage.